Converting a traditional IRA to a Roth IRA can offer big tax benefits down the road, as Roth IRA earnings aren't taxed if you follow withdrawal rules. The conversion can be a big drawback now, though, since you must pay tax on the balance of your traditional IRA in order to make it a Roth. The last thing you want is a tax penalty -- but if you don't pay enough tax on your income during the year, the IRS will charge you interest. Fortunately, you can avoid penalties with tax safe harbor rule if you plan ahead.
Establishing a Tax Safe Harbor
1. Look up what you owed in taxes for last year. This is the full amount you paid, listed on your 1040 form as "total tax".
2. Check the high earner threshold. You can find this number in Section 4 of IRS Publication 17. For 2010 taxes it was $150,000. If last year's adjusted gross income was higher than the threshold of $150,000, multiply last year's total tax bill by 1.10. If it was lower, use the full value of last years tax bill only. This value -- either 100 or 110 percent of last year's tax -- is what you need to pay in during the calendar year to avoid an underpayment penalty.
3. Verify your withholding. If you receive a regular paycheck from your employer, multiply the amount of federal tax taken from your check each pay period by the number of pay periods in the year to find your total tax paid in. If this is equal to or greater than the number in Step 2, you have a safe harbor. If not, you need to increase your withholding or make estimated payments to make up the difference.
4. Make estimated payments. If you are self-employed or don't have payroll withholding, simply divide your number from Step 2 by four to get your quarterly estimated payment.
Converting Your IRA
1. Contact your IRA custodian and inform it that you'd like to make a traditional-to-Roth IRA conversion.
2. Fill out the paperwork. Your IRA custodian will provide forms for you to complete.
3. Get a medallion-signature guarantee on the paperwork and send it in. This is not the same as a notarization -- you need to go to a bank or brokerage firm.
4. Monitor your account to ensure the change is completed. Some custodians may change your actual account number, while others will change the account type only.
5. Look for 1099-R forms in the mail the following February and a 5498 form the next May. Keep these with your tax paperwork for the year.
6. Report the conversion on your IRS Form 1040. You'll report a distribution from the traditional IRA and a contribution to the Roth IRA. Unless you are over age 59 1/2, the entire pre-tax value of your traditional IRA (as reported on the 1099-R) is taxable.
- If the tax on your whole traditional IRA balance is too high, remember that you can convert a little of the account at a time. There is no all-or-nothing requirement.
- A full IRA conversion may change your tax bracket for the year, and the safe harbor does not guarantee you won't owe additional taxes at the end of the year. If you have any concerns about your tax situation, sit down with an accountant early in the conversion year to avoid unpleasant surprises.